Optimal Inventory Order Policy for a Firm Using the LIFO Inventory Costing Method

Abstract

Many firms have adopted the last in, first out (LIFO) method of accounting for inventories in order to reduce taxable income and income tax liability in periods of rising prices. Lower tax liabilities under LIFO are not assured, however, since a LIFO company's of goods could include some very low costs from prior years, if that company's inventory purchases or production for the current year are insufficient to meet the year's demand. Moreover, even if the use of LIFO does result in a lower tax liability, the inclusion of any of the old, low costs in cost of goods sold under LIFO means that the tax liability could have been reduced even further by increasing purchases or production, such that these old costs would have remained in inventory. Increasing production or purchases, however, increases the cost of holding these extra units until the time at which they are depleted from inventory to meet demand. Such costs might include warehousing costs, interest costs, and the opportunity cost of having less funds available for other productive uses. Thus, when prices are rising, a trade-off exists between lower tax costs and higher holding costs associated with more production or purchases. This cost trade-off is further complicated by the fact that there may be a price or cost benefit to increasing purchases or production prior to the end of the time period at which tax liability is computed. In general, when